We all want financial success to have enough money to look after ourselves in retirement. But how do we go about it? What should we do with our money? The answer you get will depend on where you look:
Credit card companies encourage us to forget about savings. A life of luxury awaits us if we just borrow that little bit extra.
Ditto retail companies. Why save when the latest car, perfume, or gadget will bring you popularity now?
Self-improvement gurus tell us we need to think positive. And say affirmations in the mirror every day. Then our wealth will increase through the law of attraction.
Worse, lotteries encourage us that all we need to do is ‘play’ to assure your financial future.
It should come as no surprise that none of these pieces of advice are particularly good. Because all these different sources give advice that’s good for their financial security. Not yours.
The only person responsible for your financial success is you. Not your parents, not your employer, and not your bank. If you’re not taking that responsibility and embracing it, you’re handing it over to someone else who won’t make the right decisions for you.
So how can you obtain financial success? We’ve brought together six key concepts to help you define and reach your definition of financial success.
Key concept 1: The importance of educating yourself financially
Stocks, bonds, mutual funds, ETFs… If you’re new to investing, you’ll probably find yourself reaching for a dictionary with alarming regularity. But don’t let this put you off. You’ll never get going if you wait until you’ve learned it all. And even experienced investors are constantly learning.
That said, achieving financial success does require some understanding of a few basic concepts. And putting that understanding into practice when making even the most basic financial decisions. Many people understand these concepts. But they fail to put them into practice in everyday life.
Your net worth is the value of everything you own (assets) minus all your debts (liabilities).
To achieve financial success, you need to increase your net worth. By increasing your assets and decreasing your liabilities. Having more assets doesn’t help much. Not if your liabilities grow at a similar rate. Especially as liabilities often cost you more in interest than a similar value of assets will provide.
Some assets, such as your house, come with a liability, such as a mortgage. In this case, the liability is often relatively fixed. You owe a certain amount (plus interest, which can vary). But the value of the corresponding asset can fluctuate. Typically, house prices rise in the long-term, but this isn’t guaranteed. Over shorter periods they may fall. And potentially leave you in negative equity and unable to sell your home until prices rise again.
Compared to the alternative, paying out rent and never receiving an asset in return, buying a house is normally a sound investment.
Some assets depreciate (lose value) over time. A new car bought for $20,000 might only be worth $15,000 a year later.
This reduction in value is what makes borrowing money to buy a new car a bad investment. You pay more over time for an asset that is quickly depreciating. By the time you’ve finished paying off the loan? You’re spending far too much. You’ve now got a car that’s several years old, but you’re still paying for a new one.
An investor with a long-term view of his or her financial success might instead choose to spend less on a second-hand car. And use their left-over money to invest in assets that provide a better return.
Your cash flow measures your inflows (salaries, interest, dividends, etc.) against your outflows (rent, mortgage payments, groceries, utility bills, groceries, etc.). A positive net cash flow means you’ve earned more than you spent. While a negative cash flow means the opposite.
A positive net cash flow means you have money left over at the end of the month for savings or investing. If your cash flow is negative? You are eating into your savings. And once they’re gone, you’ll need to borrow money to pay bills.
When you invest money, you receive interest. Over time you then receive interest both on the initial principal and on past interest you’ve earned.
For example, Jenny invests $5,000 and receives a 7% return annually. After one year, she has $5,350. In the second year, she earns 7% on the $5,350, increasing it to $5724,50. Compound interest means she gains more money each year. After ten years, her investment is worth $9,836. After forty years, it is worth almost $75,000.
Compound interest means when you start investing can be more important than how much.
Compound interest can also work against you. The longer you take to pay off your debts? The bigger they’ll get. Because the interest on those debts will also earn interest.
Risk and reward
All investments carry some level of risk. The higher the risk, the higher the potential return, but the less likely you are to make that return. Your attitude to risk is something you must decide for yourself.
Diversifying, buying different stocks across different asset classes, is key to lowering your risk. If you invest all your money in one small start-up? Your investment is going to be far more volatile and riskier than investing in a wide range of established businesses across several different industries.
Key concept 2: Making your financial plan
Achieving financial success doesn’t happen by accident. Real success is only possible by making a plan and sticking to it.
Your financial goals
Create short (under a year), medium (1-5 years) and long-term (5+ years) financial goals for yourself. Taking into account what you want to achieve. For example, a short-term goal might be to save for a holiday. A medium-term goal might be to buy a new car. And a long-term goal might be to save for retirement.
Estimate what these goals will cost you. And then work out how much money you need to put aside each month to achieve them. Most people underestimate how long they will live after retiring. So you might want to err on the generous side for your long-term goals.
Achieving your goals: going from here to there
Have you worked out how much money you need to save? Then don’t be put off if the number you’ve arrived at is higher than what you’re currently achieving. This is normal. Defining your goals is the first step to achieving them. And working towards a stated value is much better than saving a bit and hoping for the best.
To achieve your financial goals, you’ll need to focus on three areas:
- Increasing cash flow
- Reducing your liabilities
- Increasing your assets
We’ll look at these areas in the next three sections.
Key concept 3: Earn more, spend less
The bigger the difference between what you earn and what you spend? The more money you have for investing and saving. This is true even if your income is quite low. If you budget effectively, use your money wisely, and invest appropriately? You can reach a far better financial position than someone who earns more but doesn’t use their money well.
Positive cash flow
If you haven’t achieved it yet, your first task should be to achieve a positive cash flow. You might use one or a combination of the following:
Change jobs or take a second job to increase your income.
Reduce monthly bills
Shop around for better deals on electricity & gas, buy food at cheaper stores, cut down on using your car.
That daily take-away coffee adds up. You can save a surprisingly large amount of money by reducing your spending on non-essential items.
The 50/30/20 rule
The 50/30/20 rule is a popular budgetary rule that allocates your income as follows:
- Necessities 50% – rent, household bills, etc.
- Luxuries 30% – entertainment, eating out, etc.
- Financial goals 20% – savings or paying off debt.
You can adjust the ratios to suit your income and requirements. If you followed the advice in the previous section? You should already have an idea how much of your income needs to go towards your financial goals.
One key step is to prioritise your savings by paying for them first. At the start of the month, rather than waiting until the end of the month and allocating whatever you have left. This forces you to save regardless of what else happens. And helps prevent you from accidentally spending the money on things you don’t need.
Getting paid what you’re worth
Unless you already have a large investment portfolio, it’s likely that your job provides you with most or all your income. Do you have budgeting skills and the willpower to save as much money as possible? Then the biggest determinant of your long-term financial success will be how much money you earn. And thus how much you have available to save.
For this reason, you should regularly check that your current salary is suitable for your role and experience. If it isn’t, ask for a raise or look for a similar job that will pay you more.
For example, if moving jobs would allow you to save just $250 more per month? After ten years (at 7% interest compounded annually) the difference to your savings would be more than $43,000. After 20 years, the difference would be almost $128,000. Small changes over a long period make a big difference.
Key concept 4: When to prioritise paying off debt
If the interest on your debt is higher than the interest you’ll receive from investing your money? You should always prioritise paying off the debt first. Although this doesn’t feel like investing or saving, it will provide a bigger improvement to your net worth.
Do you have different debts? You should always pay off the one with the highest interest rate first, for the same reason.
Your credit score and you
Paying off your debt has another advantage: it will improve your credit score. Your credit score is a score given to you by the three credit reference agencies (CallCredit, Equifax, and Experian – each provides their own score). These agencies provide lenders with insight into how risky it is to lend to you.
By paying off your credit cards and other debts, you demonstrate financial stability and improve your credit score. In turn, this allows you to get better rates and offers in the future.
Do you really need that?
Think carefully before making any purchase that requires credit. Do you need it? Credit makes us feel like we’re getting something for free. When the reality is the opposite. We’re purchasing something at the full price with a whole load of interest added on top. Before purchasing anything, consider how it will affect your net worth. And not just your immediate bank balance.
Key concept 5: Investing early pays off
We’ve already explained the power of compound interest. But just how much of an effect does it have on your long-term saving? The Center for Retirement Research at Boston College shed some light on this. By calculating how much the average person needs to save to retire if they start at different ages.
Using their data, let’s consider three different individuals. Each of whom wants to retire at 65. Abigail is 25, Bruce is 35, and Chester is 45. Each has no savings towards retirement but is going to start immediately. And each wants to retire comfortably without a decline in their living standards:
Abigail is the earliest to start saving at 25. She only needs to save about 10% of her income to retire at 65.
Bruce, 35, needs to save 15% of his income to achieve the same goal. A 50% increase on Abigail.
Chester, 45, needs to save a massive 27% of his income. Because he is starting so late, almost three times as much as Abigail.
Abigail, and even Bruce, can save easily for retirement. If they dedicate themselves to sound financial principles. For Chester, the reality is different: 27% is a huge part of your income to save.
These are only examples, and of course, the amounts will change depending on your income. But regardless of the details, it’s obvious that the earlier you start saving, the easier it will be to reach your goals.
Investing is not just for the wealthy
A key misconception that prevents people from starting early is that investing is just for the wealthy. It is true that in the past certain investments were only available if you had a certain amount of capital. But new technology is bringing down barriers. It’s reducing fees, and helping investors get started earlier, for less.
Towards the end of this guide, we’ll look at some of the ways you can start investing in your portfolio. No matter what your resources are.
Key concept 6: Protect your investments
It’s likely that at some point in your future you’ll be hit with some unexpected expenses. You might lose your job, your car might break down, or any one of a hundred other minor or major disasters.
It is important that you build up a financial cushion or rainy-day fund to cover these expenses. So you can deal with them. A 2013 report by the Federal Reserve showed that 52% of Americans didn’t have enough funds to cover an emergency of just $400. So even a small problem would result in borrowing.
Even if you have other investments, it’s still important to have an emergency fund that’s easy to access. Many investments, particularly those which offer higher interest rates, don’t allow you to withdraw money when you need it. Or they make it so it isn’t to your advantage to do so. Your other choice would be to borrow money on your credit card. Which, as we’ve already established, isn’t a good idea either.
How much of a cushion should you build? The more, the better. Six months of living expenses is a good value to aim for. And should enable you to weather most emergencies without borrowing money or impacting your investments.
Identity theft and how to protect yourself
Another growing threat to your personal financial well-being is identity theft. Thieves use your details to take out credit cards in your name, run up credit, then leave you to deal with the mess. A recent experiment by Which? tasked security experts with applying for credit cards for 42 volunteers. They only used information available online and a few educated guesses. The experts were able to apply for a credit card for three of the volunteers. Just by using information they got from searching the internet. If they can do it? Anyone can.
Protect yourself and your credit:
- Watch out for unsolicited emails phishing for your bank details. These emails will look like they come from a bank or retailer.
- Avoid sharing details online such as your address, car number plate, etc.
- Avoid using public Wi-Fi for anything but the most general browsing. Your information, including email or online banking details, could be intercepted if the network is not secure.
Putting it all together: How should you start investing to obtain financial success?
There are many different ways of investing. Real estate, gold, FOREX, futures, bonds, etc. But for this article, we will focus on stocks.
When you buy stock? You are actually becoming a part-owner in a business (or many businesses, if you buy several). Stocks fluctuate. And there is no guarantee they will go up in value, and not down. But compared to investments like bonds? You receive a relatively high potential return on average.
Stocks provide you with a return in two ways. Firstly, by increasing in value (so you can sell them for a profit later). And secondly, when a company issues a dividend, which is a share of profits given to investors. Not every stock provides dividends. So many investments rely on the value of the business going up to return a profit.
Financial advisor vs. robo-advisor vs. self-directed investor
Before you can invest, you need to choose how you’ll do it:
The traditional route. A dedicated expert invests your money (and that of others) on your behalf. This can be a good option if you want direct contact with a human advisor. But the minimum funds required to start investing are quite high. Additionally, many advisors underperform the market. Which means you’d be better off investing in an all-rounder strategy yourself and saving on the fees. Those that do beat the market on a regular basis require more money to start investing on your behalf.
These robotic advisors use machine learning to pick a solid strategy. You’ll pay lower fees and you can start with just a few thousand dollars. But you give up most of the control of your money. Which will be invested in thousands of different businesses according to your risk profile.
You make the decisions and invest your money where you want. You have more control and pay fewer fees. A simple all-rounder strategy doesn’t require too much knowledge. Although you could also focus on learning about a particular market if you want to go more in-depth.
There is no certain bet when investing. Regardless of whether you’re a self-directed investor or investing with an experienced financial advisor.
Knowing this, you should do two things. First, never invest what you can’t afford to lose. If you know you’ll need that money in six months to pay bills, don’t invest it.
Secondly, diversify your investments. By buying a diverse range of stocks, you are protected against a sudden drop in value in any one business or industry.
Take a long-term view
Blackrock reports that the average investor underperforms the S&P 500 by six percent. Mainly because investors allow their emotions to govern their decisions. Panic-selling stock when it hits a low and excitedly buying stock as it gets higher. This is the opposite of the correct strategy – you want to buy low and sell high.
The perfect information we have makes it worse. Because it allows us to check our investments every 15 minutes if we wish. Save yourself a lot of stress, time and (probably) money. Just choose a simple all-rounder strategy. And then leave it, checking it only occasionally.
Obtaining financial success is a marathon, not a sprint. Your long-term financial well-being is the cumulative result of thousands of decisions. Whether to buy that new TV or not, how much to save this month, whether to use your credit card or not, and more. You might not get every decision right, but the goal is to make as many right decisions as possible. Start saving as soon as you can, reduce your liabilities, and never stop learning.